Investors should expect more subdued returns in the second half of 2017. Equity markets have rallied in all-but interrupted manner for twelve months and are showing some signs of fatigue owing to more demanding valuations and the closing out of a positive earnings season. While geo-political risk can and has increased near-term volatility, the case for equities rests on continued moderate global growth accompanied by low inflation. So long as that combination persists, equity market sell-offs will tend to be brief and shallow.
Global bond yields have continued to oscillate within ranges, below their peak levels at the end of the first quarter. Lower than expected inflation has supported the bond market despite signs that the Federal Reserve remains committed to its policy of normalisation and expectations that the ECB will soon announce a 2018 tapering of its balance sheet.
The dollar has suffered a large depreciation over the last few months. Yet further dollar weakness appears unlikely for several reasons. First, speculative positions in the market are heavily concentrated in short dollar positions, suggesting less selling pressure going forward. Second, investors no longer anticipate that the Fed will raise interest rates before year end. That is probably wrong. Although the Fed’s next move is likely to focus on gradual reduction in its balance sheet, the majority on the FOMC believe that US monetary policy remains highly accommodative, particularly against the backdrop of a more fully employed economy. The Fed is therefore likely to raise rates one more time this year, most probably in December, which should provide support for the dollar.
The economic expansion underway in most emerging economies looks sustainable. Concerns about China’s growth are never far from the surface, particularly as the credit impulse has turned negative, suggesting some further slowing in property and fixed asset investment. Elsewhere, the green shoots of recovery are beginning to appear in Brazil and much of central Europe is benefitting from stronger European growth. Overall, moderate growth in the emerging complex is probable over the balance of 2017.
Nevertheless, we have adopted a somewhat more cautious stance towards asset allocation. We have pared back positions in global equities, which have rallied strongly and will enjoy less support as the earnings season concludes. Bond markets remain richly valued and ahead of upcoming monetary policy normalisation we remain short duration. We are taking more interest in alternative strategies, including traditional hedge fund relative value strategies as well as target return approaches. Target return is particularly well-suited for this environment insofar as it may offer weakly correlated returns to both global equities and bonds, as well as low volatility and stable returns.